Black-Litterman Model - Market Caps

Black-Litterman Model (BLM)

As an introduction topic for our blog, let’s discuss Market Capitalization in the BLM, why it matters and how it can help determine forward-looking returns.

BLM vs. Historical Model

Why would you use the BLM over the Historical Model? Well, first the forecasted returns tend to be poorly diversified with the Historical Model. The approach does not take into account what human investors consider intuitive and well-diversified because it’s purely focused on maximizing expected return for each level of risk. Also, it’s not necessarily realistic to assume that markets will move the exact same in the future as they have over the past 30 years. More specifically: the historical performance may not be reflected in the future.

Three Factors Contributing to the BLM

  • the risk premium of the market portfolio above and beyond the risk-free rate
  • the historical covariance between the different pairs of assets
  • the market capitalization or better known as market caps

Market Caps in the BLM

As explained above using only historical returns to forecast performance can be unintuitive and cause poorly diversified portfolios. You want to create a market portfolio that will diversify the assets within the portfolio which can be considered to be the alternate consensus portfolio. By far, using markets caps is one of the best ways to achieve this goal. The portfolio is created where the weights of the asset classes are proportional to their respective market caps. Let’s discuss this in a little more detail.

The main concept of the BLM is surrounded by the idea that there is an “equilibrium portfolio”, or market portfolio of your investible asset classes. The relative weights of these asset classes are determined by the aggregate amount of dollars whether that is Euros, Pounds, Swiss Francs or whatever currencies that are invested into these assets worldwide.

Why do we do this and how does it work?

The dollars invested include aggregate opinions of investors throughout the world. Let’s say for example there were $4.2 trillion invested in Emerging Markets at the end of 2010. So one day everyone woke up and decided the best performance was actually going to be found in Brazil, Hungary, Russia and other emerging countries. You would therefore probably see a much higher number than $4.2 trillion. You might see something like $5 or $6 trillion. If everyone had an expectation for high returns within that asset class, their money would shift towards that asset class.

Summary

To summarize our discussion, using market caps verifies a market portfolio that is well-diversified and removes one of the oversights of using the Historical Model to forecast returns. With the combination of the three elements used in the BLM, the mean-variance optimization calculation to predict returns becomes intuitive and well-diversified for the investor.

TAGS: Investment